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The recent growth of private markets has been typical. Indeed, private funds, which include venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activities. According to McKinsey consultants, private market assets under management reached $13.1tn by 2023 and growing at close to 20 percent annually since 2018.
For many years the private markets have raised more equity than the public markets, where the decline due to share buybacks and takeover activity has not been offset by the decline in the volume of new issues. The mobility of private markets means that companies can remain private indefinitely, without having to worry about access to capital.
One result is a significant increase in equity market capitalization and economic transparency for investors, policy makers and the public. Note that disclosure requirements are largely a matter of contract rather than regulation.
Much of this growth has occurred against a backdrop of extremely low interest rates since the 2007-08 financial crisis. McKinsey points out that about two-thirds of the total return on buyout transactions entered into in 2010 or later and exited in 2021 or earlier can be linked to broad movements in market valuations and increases, rather than improved efficiency.
Today these spiritual benefits are no longer available. Borrowing costs have risen due to tighter monetary policy, and private equity managers have had difficulty selling portfolio companies in a weak market environment. However, institutional investors have a growing appetite for illegal investments. And large asset managers want to attract wealthy investors to the area.
With public equity nearing an all-time high, private equity is seen as providing better creative exposure within an ownership structure that ensures greater oversight and accountability than the quoted sector. Meanwhile, half of the funds surveyed by the Financial Forum and Financial Institutions, a UK think tank, said they expect to increase their exposure to private credit in the next 12 months – from about a quarter last year.
At the same time politicians, especially in the UK, are adding momentum to this crisis, with the aim of encouraging pension funds to invest in risky assets, including infrastructure. Across Europe, regulators are relaxing liquidity and depreciation rules for defined benefit pension plans.
Whether investors will reap the illiquidity premium in these key markets remains unclear. Get together report by asset manager Amundi and Do research highlights high fees and charges in private markets. It also explains the lack of transparency of the investment process and evaluation of performance, the high cost of conflicts caused by the premature exit of portfolio companies, the high distribution of the final investment returns and the high level of dry powder – funds allocated but not invested, waiting for opportunities. waking up. The report warns that large inflows into alternative assets could reduce returns.
There are broader economic questions about the growth of private markets. As Allison Herren Lee, former commissioner of the US Securities and Exchange Commission, has pointed out besides, private markets are highly dependent on the ability to free ride on the transparency of information and prices in public markets. And as the public markets continue to shrink, so does the cost of that funding. The lack of transparency in private markets can also lead to a misallocation of capital, according to Herren Lee.
Also the private equity model is not suitable for certain types of infrastructure investment, such as the experience of British water industry shows. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owners of a long-term good or service. This is because they have no incentive to make short-term sacrifices for long-term innovation or maintenance.
Most of the variables after switching to the private market are controlled. Stricter capital adequacy requirements for banks after the financial crisis led to lending to less regulated non-bank financial institutions. This was not a bad thing in the sense that there are new useful sources of credit for small and medium-sized companies. But the associated risks are difficult to track.
According to Palladino and Karlewicz, private debt funds pose a unique set of potential systemic risks to the broader financial system due to their relationship with the regulated banking sector, the lack of transparency of loan terms, the illiquid nature of loans and the inconsistent growth potential. with the needs of limited partners (investors) to withdraw money.
For its part, the IMF has argued that the rapid growth of private debt, as well as increased competition for banks in large contracts and pressure to use capital, can lead to inflation and unnecessary conditions, including low levels of underwriting and reduction. covenants, raising the risk of future credit losses. No prizes for guessing where the next financial crisis will come from.